Weighted Average Cost of Capital (WACC): How to Calculate It?

Weighted Average Cost of Capital (WACC) is the average rate of return that the company is expected to pay security holders for financing its assets. WACC represents the minimum return that the company needs to earn on its existing assets to satisfy capital providers. It is the firm’s average cost of capital from every source including different types of equity and debt holders. 

Table of Contents

• How to Calculate Weighted Average Cost of Capital (WACC)?
• Example to Calculate WACC
• How does the Weighted Average Cost of Capital Help Businesses?

How to Calculate Weighted Average Cost of Capital (WACC)?

To calculate the Weighted Average Cost of Capital (WACC), the following formula is used:

Here, the symbols mentioned above in the WACC formula represent the following:

• Market value of Firm's equity (E)= It is the total value of the company's outstanding shares present in the stock market. To calculate it, the current market price per share is multiplied by the total number of outstanding shares.
• Market Value of Firm's debt (D)= It is the total value of outstanding debts issued by the company as valued by the market. 
• Total Market value of the company’s financing (V) = It represents the entire value of the funds that the company uses for its operations and investing opportunities. It is calculated by adding E and D.
• Cost of Equity (Re)= It is the return expected by investors for investing in the equity of the company. The cost of equity is estimated using the Capital Asset Pricing Model (CAPM). The higher the risk, the higher is the cost of equity.
• Debt Cost (Rd)= It is the effective rate that the company need to pay on borrowed funds. It is adjusted for tax savings since interest payments are tax-deductible. When the company pays interest for debt, it is used as a deduction to calculate its tax.  
• Corporate Tax Rate (Tc)= It is the percentage of the company's profit that is paid as tax to the government, It varies according to state and country tax guidelines.
• Proportional Weight of Equity (E/V)= It represents how much of the company’s financing comes from equity.
• Proportional Weight of Debt (D/V)= It represents how much of the company’s financing comes from debt. 

Example to Calculate WACC

A consumer electronics manufacturer is looking to evaluate its cost of capital. The company is publicly traded and it has recently issued bonds. Let us calculate its Weighted Average Cost of Capital (WACC) to calculate the average cost incurred for its financing sources. Here are its financial figures:

• Market Value of Equity (E): $800 million (as per current stock market valuation)
• Market Value of Debt (D): $300 million (based on market value of outstanding bonds)
• Cost of Equity (Re): 10% (based on the Capital Asset Pricing Model)
• Cost of Debt (Rd): 6% (average interest rate on bond issues)
• Corporate Tax Rate (Tc): 25% (current corporate tax rate)

Now, let us calculate WACC using the above-mentioned formula:

Step 1: Calculate the Total Market Value of the Company's Financing (V)

This is the sum of the market value of the company's equity (E) and the market value of its debt (D).

V=E+D

V= $800 million + $300 million

V= $800 million + $300million

V = $ 1,100 million

Step 2: Calculate the Proportional Weights of Equity and Debt

These weights are calculated as the proportion of each financing source (equity and debt) in the total financing.

Weight of Equity= E/V = $800 million/ $1,100 million = 72.73%

Weigh of Debt = D/V = $800 million/ $1,100 million =  27.27%

Step 3: Calculate the WACC

The WACC is calculated using the formula:

WACC = (0.7273×10%) + (0.2727 × 6%×(1−25%))

WACC=0.07273 + 0.2727 × 0.06 × 0.75

WACC= 0.07273 + 0.01225

WACC=0.07273 + 0.01225

WACC= 8.498%

The WACC for the consumer electronics manufacturer is 8.498%. This rate represents the average rate of return the company must earn on its investments to satisfy its shareholders and debt holders.

How does the Weighted Average Cost of Capital Help Businesses?

Weighted Average Cost of Capital impacts businesses in the following ways:

• Benchmark for Investment Decisions: WACC serves as a hurdle rate or benchmark for evaluating the return on potential investment projects. Projects with returns exceeding the WACC can add value to the company.
• Performance Measurement: It helps in assessing the performance of a company. A return on investment higher than the WACC indicates efficient use of capital.
• Capital Budgeting: WACC is used in discounted cash flow (DCF) analysis for valuing projects and companies, playing a key role in capital budgeting decisions.
• Cost of Financing: It provides insight into the average cost a company pays for the capital it uses, helping in understanding the expense of financing operations and growth with equity and debt.
• Optimal Capital Structure: WACC helps in determining the company's optimal capital structure – the proportion of debt and equity financing that minimizes the WACC and maximizes corporate value.
• Risk Assessment: Reflects the risk of the company’s operations and the mix of its financing sources. A higher WACC indicates higher risk associated with the business.
• Strategic Planning: Aids in strategic planning by providing a clear cost metric against which management can weigh the projected returns from strategic initiatives.
• Investor Attraction: A lower WACC can make a company more attractive to investors, as it suggests the company is generating greater returns relative to its risk.
• Mergers and Acquisitions: Used in evaluating mergers and acquisitions – understanding whether the acquisition will generate sufficient returns above the combined company's WACC.
• Shareholder Value: Ultimately, by focusing on projects and strategies that exceed the WACC, a company can increase shareholder value.